New IRS Guidance Boosts Confidence and Investment Potential in Opportunity Zone Program
On October 19, 2018, the IRS issued highly anticipated proposed regulations on opportunity zones. The guidance and interpretations in these regulations provide a clearer path for investment in the new “Opportunity Zone” program, a program that incentivizes the movement of capital into those low-income communities in all 50 states, the District of Columbia, and 5 U.S. territories now designated as qualified opportunity zones (“Opportunity Zones”) by offering taxpayers who invest in these Opportunity Zones 3 separate tax benefits – (1) temporary capital gain deferral; (2) permanent exclusion of a portion of the deferred capital gain; and (3) permanent exclusion of post-acquisition appreciation in the investment.
Unlike most proposed regulations, taxpayers are allowed to rely on these proposed regulations as long as certain requirements are met, which allows investors, fund managers, real estate developers and business owners to move forward with confidence. The proposed regulations address several issues that are fundamental to the Opportunity Zone program, including but not limited to the key aspects outlined below.
Capital Gain Eligible for Deferral. The proposed regulations clarify that only “capital gain” is eligible for deferral through investment in a qualified opportunity fund (“Opportunity Fund”) and define gain eligible for deferral as any gain that is treated as capital gain for Federal income tax purposes. Thus, any gain that a taxpayer is required to include in its computation of capital gain is eligible to be deferred, including capital gain from an actual or deemed sale or exchange, both short-term and long-term capital gain, Code Section 1231 gain (gain from the sale of real estate used in a trade or business), and unrecaptured Code Section 1250 gain (capital gain taxed at a higher capital gains rate). The proposed regulations provide that all of the deferred capital gain’s tax attributes are preserved, meaning the character of capital gain as short-term versus long-term or as Code Section 1250 gain, etc. is retained and applies when the taxpayer reports the gain. Gain not eligible for deferral includes Code Sections 1245 and 1250 depreciation recapture (taxed as ordinary income) and capital gain from a sale or exchange with a related person (which applies 20% as the threshold of common ownership for a “related party”).
Gain from Pass-Through Entities. Under the proposed regulations, with respect to eligible capital gains from a sale or exchange of an asset by a pass-through entity (i.e. partnership, S corporation, trust or estate), either the pass-through entity can elect to defer all or part of the gain or, to the extent that the pass-through entity does not so elect, the pass-through owner(s) to whom the entity allocates such capital gain may elect to defer all or part of the gain. If the pass-through entity is making the election to defer, the 180-day period for the pass-through entity begins on the date that the pass-through entity sells or exchanges the asset and realizes the gain. If a pass-through owner is going to elect to defer the gain, the default rule is that the pass-through owner’s 180-day period does not begin until the last day of the pass-through entity taxable year in which the realization event occurred – which is the date on which the pass-through owner “recognizes” its allocable share of the gain absent an election to defer. As an alternative, the pass-through owner may elect to treat the pass-through owner’s own 180-day period as being the same as the pass-through entity’s 180-day period (thus, it would begin on the date of the realization event).
How to Make Gain Deferral Election. The IRS currently anticipates that a taxpayer will make a deferral election on Form 8949 and attach that form to the taxpayer’s Federal income tax return for the taxable year in which the taxpayer would have recognized the gain if the taxpayer had not elected deferral.
Eligible Opportunity Fund Investment. The investment in an Opportunity Fund must be an equity interest in order to qualify for the tax benefits. Thus, debt does not qualify (note, though, that the proposed regulations allow an Opportunity Fund investor to use that interest as collateral for a loan). The proposed regulations clarify that an equity interest includes preferred stock as well as a partnership interest with special allocations, which allows the use of capital structures that provide non-pro rata distributions.
Different Holding Periods for Opportunity Fund Investments. The proposed regulations provide that if a taxpayer owns indistinguishable interests (e.g., equivalent shares of stock or partnership interests with identical rights) in an Opportunity Fund that have different attributes and the taxpayer disposes of less than all of its interests on a single day, the taxpayer must identify the interest(s) disposed of using a first-in first-out (FIFO) method, which is important because some tax incentives of the Opportunity Zone program are based on the investors’ holding periods (5,7, and 10 years). If, after a taxpayer applies the FIFO method, a taxpayer is treated as having disposed of less than all of the investment interests the taxpayer acquired on a single day and those interests have different characteristics, the taxpayer will apply the pro rata method to determine which interests it disposed of.
Period that Investors May Invest in Opportunity Zones and Hold Opportunity Fund Interests. The proposed regulations clarify that investors may receive the benefit of a 10-year holding period (i.e. the ability to make the election to increase basis to fair market value on sale of an Opportunity Fund interest) notwithstanding that the designation of one or more qualified opportunity zones may cease to be in effect upon the expiration of the designation of the Opportunity Zone on Dec. 31, 2028. The proposed regulations allow a taxpayer to make this election for dispositions of qualifying investments occurring after the 10-year hold and before January 1, 2048. Any investment in an Opportunity Fund must be sold or exchanged by December 31, 2047. Treasury and IRS have requested comments on whether there is a better way to handle the expiration of the availability of the basis step-up election.
Land Value Need Not Be Included in Calculating “Substantial Improvement.” The definition of “qualified opportunity zone business property” under the Opportunity Zone statute includes, among other things, property in an Opportunity Zone that the Opportunity Fund substantially improves and property is “substantially improved” if, during any 30-month period after the date of acquisition of such property, the Opportunity Fund invests sufficient capital to double the original adjusted basis of the property. The proposed regulations clarify that the Opportunity Fund need not include the value of the land in the “substantial improvement” calculation, which clarifies that investment is allowed in existing dilapidated infrastructure that may not have otherwise qualified under the opportunity zone statute. Without this clarification it seemed that in the case of a real estate investment, very few existing structures would qualify and that the most likely type of qualifying investment would be the development of raw land.
Other October 19, 2018 IRS Releases. The IRS also issued Rev. Rul. 2018-29 that addresses the application of the original use and substantial improvement tests to the purchase of land with an existing building in an opportunity zone as well as a draft Opportunity Fund self-certification form (Form 8996) and accompanying instructions thereto. Note that additional IRS guidance is expected by December 2018.
This blog was written by Kendra Merchant at Miles & Stockbridge.
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